COLLEGE SAVINGS 101

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529 E-ditorials

01-2: The Excedrin IRA
Joe Hurley
Tuesday, March 13th 2001

SIX HOURS. That is the official IRS estimate of the time it takes to properly report a withdrawal from an Education IRA on your child’s tax return. Calling the Education IRA a joke may not be far from the truth. First, Congress comes up with this idea for a tax-free savings vehicle for college, but it limits total contributions for any one child to only $500 per year. Then the IRS creates a bookkeeping and paperwork nightmare that will have you, or your accountant, banging your head against a wall.

Can it really take six hours? The answer is yes, perhaps even more. Take a look at federal Form 8606. First you have to determine if your Education IRA withdrawal is a qualified or non-qualified withdrawal. There are lots of rules there. Assuming at least some of it is qualified, you then have to decide if it makes sense to elect out of tax-exempt treatment, so that you or your child can claim the Hope Scholarship credit or Lifetime Learning credit. You will need to do some heavy pencil pushing, as this is not an obvious decision. You will also have to complete a 17-line worksheet in the instructions to Form 8606 to figure the tax basis of your Education IRA and the amount of distributed earnings. If all this sounds complicated, believe me, it is.

Now assume your child is unfortunate enough to have a parent (you) contributing to the Education IRA in the same year that some other relative contributes to a 529 plan for him or her. This means your kid owes a penalty to the IRS. There is also a form (Form 5329) for that. And the IRS says that it will take you FIVE HOURS to complete that form.

These hours are really starting to add up. Maybe you think your accountant should be jumping for joy because the extra complications mean higher fees. Think again. Assume your super-efficient accountant can do all the work in only two hours. At $125 per hour, that’s an additional $250 charge to you. You will not be happy with this extra bill, particularly when you realize that the tax savings on a $500 annual investment in an Education IRA is not worth it. You may even object to paying that fee. This makes your accountant unhappy.

As a CPA in practice for over 20 years, I know this kind of unhappiness. The same client who is appreciative of the time and effort needed for their own tax return is the one who cannot understand why a kid’s return should cost more than a few dollars. I have seen this happen with the kiddie tax. I have seen it with stripped Treasury securities that require annual computations of discount income. And now I am seeing it with the Education IRA.

All this brings me to one of the least-appreciated aspects of 529 plans. A 529 plan is wonderfully simple when it comes to tax reporting. The sponsoring state, not you, is responsible for all the income tax recordkeeping. There are no extra federal forms for you to complete. There are no 17-line worksheets. There are no federal penalties to be computed and paid. You receive a Form 1099 from the state at the end of the year in which a withdrawal is taken. There is just one figure on that form, the amount of income to report on your child’s tax return. It is just as easy if you take a non-qualified withdrawal. The state withholds its penalty from the withdrawal, and in January sends the Form 1099 to you. The overall savings in terms of time, aggravation, and professional tax preparation bills can be significant. (This sense of relief may not extend to your state tax returns, however, where special tax breaks may give rise to added complications.)

Let’s hope that the tax reporting for your 529 account remains this simple in the future. It may not. If Congress and the President approve tax exemption of 529 withdrawals (and chances of that happening are getting better all the time), look for new recordkeeping and reporting requirements. One recent bill in Congress would even add a federal penalty tax to non-qualified 529 withdrawals, just like non-qualified Education IRA withdrawals. Then we would be in the same boat under either savings alternative.

I am beginning to wonder if tax exemption is really worth the trouble.

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